A hot topic this year on the cross-border regulatory conference circuit has been the status of ESMA’s investigation into UCITS share classes. You see, back in December 2014, ESMA released a surprise discussion paper on the share classes of UCITS. The purpose of the paper was to create a harmonized definition of share classes under UCITS and describe how share classes may differ from each other.
The big takeaway for the industry was the statement:
ESMA believes that interest rate hedging performed at the level of share classes does not comply with the principle of having the same investment strategy.”
This line seemed to preclude the use of duration hedging and, by extension, portfolio hedging at the share class level. In recent years, both practices have become increasingly common in Ireland and Luxembourg, which are, incidentally, the two biggest UCITS domiciles.
What vexed the industry most was the fact that since the comment period for the discussion paper closed in March 2015, ESMA went radio silent on the topic. This created uncertainty for the industry. The regulators in Luxembourg and Ireland (the CSSF and CBI, respectively) stopped approving any new duration share classes in anticipation of ESMA’s final report.
On 7 April, ESMA broke its silence with the release of a new discussion paper on UCITS share classes, which builds on the feedback received on the 2014 discussion paper.
In the paper, ESMA identified four high-level principles for UCITS share classes:
- Common investment objective
Share classes of the same fund should have a common investment objective reflected by a common pool of assets
UCITS management companies should implement appropriate procedures to minimize the risk that features specific to one share class could have a potentially adverse impact on other share classes of the same fund
All features of the share class should be pre-determined before it is set up
Differences between share classes of the same fund should be disclosed to investors when they have a choice between two or more classes
Most of the discussion paper is very much in line with what ESMA published in 2014, but there are a couple items of particular note.
First, if it wasn’t already, ESMA makes its position on things like duration hedging perfectly clear in this statement:
ESMA doubts whether share classes with overlays that are not linked to FX hedging, such as duration-risk-hedged or volatility-risk-hedged share classes could be seen as compatible with these operational principles, as they might not be implemented according to a detailed, pre-defined, and transparent hedging strategy.
So, it seems likely that share class duration hedging and its ilk are not long for this world, which means managers will have to unwind existing duration hedging share classes and either offer the unhedged share class or set up a parallel fund structure and transfer the investors. In fact, during the moratorium on new duration hedge share classes some asset managers decided to launch new funds.
The other big development in the ESMA paper was the introduction of the concept of “pre-determination,” which it articulates as follows:
ESMA is therefore of the view that all features of a share class should be pre-determined before the share class is set up, in order to allow the potential investor in the fund to gain a full overview on the rights and/or features attributed to his investment. In share classes with hedging arrangements, this pre-determination should also apply to the kinds of risk which are to be hedged out systematically. If the share class is created after the fund in which the share class is included has been authorised, the new share class should not affect the features and characteristics of the fund for the investors already invested in other classes of the fund.”
Essentially, ESMA is saying upon the launch of a fund, a manager must determine all the types of share class hedging arrangements that there will ever be. Depending on the final shape of the “pre-determination” rules, this could reduce the potential for managers to add new types of share classes in the future. This, in turn, could mean either an increase in new fund launches or a decrease in investor choice, neither of which is a great outcome. As it stands, the likely prohibition on duration hedging is probably going to lead to a rash of new fund launches.
The deadline for responding to the discussion paper is 6 June 2016. While the die looks cast for the fate of duration hedging, the issue of pre-determination shows there is still much to play for.